Interest rate risk may sound like an odd type of risk, but in fact, it’s a common consideration for investors. Be aware that interest rates change on a regular basis, causing some challenging moments. Bank set interest rates, and the primary institution to watch closely is the Federal Reserve which is in effect, the country’s central bank. The fed raises or lower interest rates, action that, in turn, cause banks to raise or lower interest rates accordingly. Interest rate changes affect consumers, businesses, and of course, investors.
The scenario outlined in the following paragraphs gives you a generic introduction to the way fluctuating interest rate risk can affect investors in general.
Suppose that you buy a long-term, high-quality corporate bond and get a yield of six percent. Your money is safe, and your return is locked in at six percent. Whew! That’s a guaranteed six percent. Not bad, huh? But what happens if, after you commit your money, interest rates increase to eight percent? You lose the opportunity to get that extra two percent interest. The only way to get out of your six percent bond is to sell it at current market values and use the money to reinvest at the higher rate.
The only problem with this scenario is that the six percent bond is likely to drop in value because interest rates rose. Why? Say that the investor is Tom and the bond yielding six percent is a corporate bond issued by Lucin-Muny. According to the bond agreement. LM must pay six percent during the life of the bond and then, upon maturity pay the principal. If tom buy $10000 of LM bonds on the day they are issued , he get $600 every year for as long as he holds the bonds. If he holds on until maturity, he gets back his $10000. So far so good right? The plot thickens, however.
Say that he decides to sell the bond long before maturity and that, at the time of the sale, interest rates in the market have risen to 8 percent. Now what? The reality is that no one is going to want his six percent bond if the market is offering bonds at 8 percent. What’s tom do? He can’t change the face rate of six percent, and he can’t change the fact that only $600 is paid each year for the life of the bond. What has to change so that current investors get the equivalent yield of eight percent? If you said “The bond’s value has to go down” bingo! In this example, the bond’s market value need to drop to $7500 so that investors buying the bond get an equivalent yield of eight percent. Here’s how that figures:
Now investors still get $600 annually. However, $600 is equal to 8 percent of $7500. Therefore, even though investors get the face rate of 6 percent, they get a yield of 8 percent because the actual investment amount is $7500. In presents itself. Bob finds out that you can have a good company with a good bond, yet you still lose $2500 because of the change in the interest rate. Of course, if Tom doesn’t sell, he doesn’t realize that loss.
You can lose money in an apparently sound investment because of something that sounds as harmless as “interest rate have changed.”
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